The Fruits of Civilization (31-2-5) Stock Market continued


One of the laughable myths economists hold about the stock market is that it is an efficient way to allocate capital. This is based upon the assumption that investors have some savvy about the products of the companies they put their money on.

When a new product is preannounced, the short-term reaction of the stock market is unreliable. It’s really a flip of a coin. ~ Turkish-American marketing professor Ahmet Kirca

General Motors’ stock got a boost when it announced in 2003 the new Chevy SSR, a retro-style pickup truck. Yet SSR sales never took off, and the model was discontinued 3 years later. Conversely, Honda’s sole entry in the highly competitive US truck market – the Ridgeline – survived investors’ initial negative reaction in 2005 to haul in profits for many years.

Apple Computer stock dipped 6.7% in the 3 days after it announced its new iPad tablet computer in 2010. The iPad went on to be wildly successful.

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In a market economy, where transactions for exchanging goods are unrestrained, prices supposedly reflect a gyre of interaction between supply and demand, albeit with at least one (more) glaringly unrealistic constraint: if the same thing is for sale in various places, economists have faith that the law of one price holds true. The law is an axiomatic belief: that in an efficient market, identical goods all have the same price. The law of one price is a nicety that has no factual basis: bargain bins and price-gouging illustrate the point, to the respective delight and consternation of consumers.

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Conventional economists believe that markets are naturally efficient, but admit that distortions do occur, owing to various causes: such as buyers not having perfect information or government regulations which tamper with the wondrous workings of the otherwise free market.

Markets are not autonomous, spontaneous phenomena operating according to their own natural laws. In reality, markets are social constructions whose rules are set by institutions and regulated by governments. ~ Oxfam International

The idea that buyers and sellers possess perfect information is theoretical tripe which everyday experience contradicts.

The difficulty of distinguishing good quality from bad is inherent in the business world and may indeed explain many economic institutions. ~ George Akerlof

Information asymmetry affects both pricing and quality, resulting in adverse selection: an economic transaction with inherent risk due to lack of information. Sellers know more about the quality of the goods they offer than do buyers. Hence, there is an incentive for sellers to offer lesser-quality goods than expected for the price (given cost and quality going hand-in-hand).

The situation in the market is complex. Whereas market leaders with esteemed brands gradually erode product quality and sometimes subtlety raise prices (e.g., same price, smaller portions), upstarts make their way up via better quality at lower prices. For both, information asymmetry is in play: working for the leader and against the upstart until reputations change. This is only one way that information asymmetry can be a powerful force in marketplace dynamics.

Consider a market in which goods are sold honestly or dishonestly; quality may be represented, or it may be misrepresented. The purchaser’s problem, of course, is to identify quality. The cost of dishonesty lies not only in the amount by which the purchaser is cheated; the cost also must include the loss incurred from driving legitimate business out of existence. Dishonesty in business is a serious problem in underdeveloped countries. ~ George Akerlof

In the instance of health insurance, buyers know more about their health than does the insurance company. Insurers prudently assume something near the worst case, which inordinately raises the price for those in good shape.

Medical insurance is least available to those who need it most, for insurance companies do their own “adverse selection.” The principle of adverse selection is potentially present in all lines of insurance. ~ George Akerlof

Minorities have long suffered adverse selection in getting jobs. Governments in some countries, including the United States, have intervened to correct a heuristic for economic efficiency.

Employers may refuse to hire members of minority groups for certain types of jobs. This decision may not reflect irrationality or prejudice – but profit maximization. For race may serve as a good statistic for the applicant’s social background, quality of schooling, and general job capabilities. ~ George Akerlof

Simply put, markets are never efficient. Sellers charge as much as they can get away, and consumers buy what they must or can afford, all depending on individual needs and tastes, and availability at the moment.